The following article was originally published at The Agile Trader on March 30, 2008.

Dear Speculators,

In the December 23 edition of this note entitled, "A Check-List for Early "08" I asked the complex question:

Is the economy robust enough, and are policymakers good enough at policy-making, to avert a bona fide catastrophe without severely exacerbating the underlying (excess) of credit and liquidity that created these problems in the first place?

In the wake of Treasury Secretary Paulson's proposals on financial-market regulations made on Monday, and following a host of creative steps taken by the Fed to pump liquidity into both the economy as a whole (via interest-rate cuts), and specifically into the nooks and crannies that really need it (via less traditional actions), it strikes me that the market is still basically asking itself this same question. The "recession" thesis is essentially baked into economists' cakes right now, as it is into the Treasury Inflation Protected Securities (TIPS) markets.

The 5-Yr TIPS market is currently discounting 0.47% annual real growth in the US economy over that time frame (blue line below), a number that's about 1.1% below the worst 5-year growth rate for any period since WWII.

Meanwhile, inflation hawks should take note that the Breakeven Inflation Rate (red line above, which is this market's best guess at what CPI inflation will average during the next 5 years) remains snugly within its 2-2.5% range, now at 2.19%.

Bond-market investors are much more concerned about an economic slowdown than they are about the acceleration of inflation from a slow trot to a gallop. And it is this concern over a slowdown (expressed as the decline in the blue line above from 2.7% last July to just about 0% in early march) that has been strongly associated with the SPX's decline from the 1500s down into the 1200s.

At this point the stock market concurs with the credit market in terms of being skeptical that the Fed will be able to re-flate the economy. (The stress on the economy is expressed as a low real yield in the TIPS market.)

That stress derives significantly from the absence of any bounce-back in the prices of mortgage-backed securities. Even in the context of the Fed's announced acceptance of Triple A mortgage bonds as collateral for loaning Treasuries, the ABX Index charted below (which tracks a recently issue Triple A tranche of mortgage bonds) continues to trade barely above 50 cents on the dollar.

Despite the fact that this ABX Index has plummeted to its downside target near 52, there has been only the deadest of dead-cat bounces on the chart. Buyers remain terrified of anything related to the word "mortgage."

Our 3rd and final barometer of distress in the credit market is the TED Spread (the difference between the 3-month LIBOR yield and the 3-month Treasury yield).

While the TED Spread (red line above) has fallen following a 3rd run up to the 2% area, it remains elevated, above 1.3%, and continues to express hesitancy on the part of banks to lend to one another. Why? Because they're terrified of other banks' ability to re-pay loans.

In sum, the credit markets remain "off the bus," which is to say that that investors, in aggregate continue to doubt that policymakers will be able to re-flate the economy any time soon.

In the stock market, the earnings picture continues to deteriorate for the SPX. The consensus for forward earnings continues to decline (using a conservative 0% Y/Y growth rate for 1Q09 earnings for now). On a time-weighted basis, the consensus for forward 52-week operating earnings has fallen from more than $102 in October down to the $96 area as of Friday (blue line below).

Trailing 52-wk operating earnings (yellow line above) have fallen from more than $92 to about $81. And trailing reported earnings have fallen the hardest of all, from more than $86 down to about $63.

The precipitous decline in reported earnings generates a large gap between the pink and yellow lines, which many site as a decline in the quality of earnings. The widening gap between the pink and yellow lines is a function of an increase in write-downs and "one-off" charges that companies take to earnings. These so called "one-off" write-downs tend to shake investor confidence in the veracity of corporate earnings reports, and consequently tend to be associated with a weak stock market.

In the current environment, the earnings problems have largely been confined to the Financial sector, as is painfully obvious on this next chart.

Signifcant deterioration has also been seen in Consumer Discretionary stocks, as a function of the spent-up, over-leveraged consumer. And, of course, earnings trends in the Energy sector remain terrifically strong. Expectations in the other 8 sectors remain fairly solid, however. So, in terms of how broad the damage to earnings will be in the stock market, for now we are seeing pretty good containment of the problem.

But, here's the thing...

Look at this next chart of quarterly estimates for Financial Sector earnings.

The pink line tracks estimates in the sector for 3Q07. Now, note what happened to the consensus at the end of 3Q07 (9/30/07). That's when the problems really began to show up, as Financial companies missed estimates.

Now, look at what happened to the consensus for 4Q07 (yellow line) once that quarter was over (1/1/08). Boom. Another chapter in the same story but worse.

Now, look at the consensus for 1Q08 (light blue line) as we end the quarter (3/31/08). There's been a very recent sharp drop in the consensus as we head into the teeth of reporting season.

Are the bulk of the downside surprises already being discounted? Or will there be more shoes to drop this quarter? If the light blue line plummets during April, then the stock market may well see another leg down. But if the blue line holds steady or (heaven forbid) rises, then we'll very likely see a lot of short-covering in the stock market.

Returning to the subject of policymakers and the market's confidence in them, this next chart shows that the Fed's reaction function continues to be more aggressively pre-emptive than it has been in more than a decade.

Historically there has been a strong correlation between the Y/Y change in forward earnings expectations and the Y/Y change in the Fed Funds rate (between the red and blue lines below).

With the red line now well below the blue line, we can see that the Fed has dropped the Fed Funds Rate at the fastest rate since shortly after 9/11, and faster than at any other time in the last 13 years. So, while there are many pundits out there talking about the Fed being behind the curve, doing too little too late, or pushing on a string, relative to past behavior, they are making a solid effort to be pre-emptive of slowdowns in the economy and in earnings growth.

Now, I haven't had the TV on a lot lately, except to watch some tennis, but I still have not heard a single reference this year to the old saw, "Don't fight the Fed."

It continues to be my view that it does pay to fight the Fed...but only for a little while. Which is another way of saying that there is generally some lag time between the Fed's trying to get something and when they get it. Well, in looking at how the Fed has dropped the Fed Funds rate, as well as considering all the other creative actions they've taken to shore up bank balance sheets and restore confidence in credit markets, I don't think there's any way to ignore the fact that the "fight the Fed" thesis is getting a little long in the tooth right now.

"Don't fight the Fed" should start to make itself heard in the media in the next 1-2 months, in my guess-timate. Why? Well, at least in part, because bonds (expressing the flight to quality) remain over-loved, and stocks (as a function of fear) remain under-loved.

The 10-Yr Treasury yield is now about 3.5%. And the SPX forward earnings yield is about 7.3%. The difference (7.3% - 3.5%) of 3.8% represents the excess yield, relative to risk-free Treasuries, that investors demand in order to assume the risk of investing in the stock market. We call this excess yield the Equity Risk Premium (ERP, pink line below). Historically, when ERP is high, the market tends to perform very well over the ensuing 2.5 years. And when ERP is very low, the market tends to perform less well (or poorly).

Over the long term, ERP has tended to average about 0.2%, very close to zero. And the Fed's Fair Value calculation assumes that ERP is 0%. Presently that would give us a Fair Value of Forward Earnings divided by the 10-Yr Treasury Yield:

$96.26 / 3.466% = 2,777

Wacky, eh? Probably not a helpful model, as it suggests that the SPX is currently trading at less than half of Fair Value.

Since 9/11, in a world perceived to be increasingly risky, median ERP has been 2.03%.
ERP is now very high at 3.8%, in roughly the 95th percentile of all weekly readings since 1960.

Using the post-9/11 median ERP as a kind of baseline against which to compare the perceived risk in the market (we're not looking for a return to historical norms, but just to post 9/11 norms), let's look at what I call the Risk Adjusted Fair Value (RAFV) of the SPX. RAFV is calculated by dividing forward earnings by the sum of the 10-Yr Treasury yield and the median post-9/11 ERP:

RAFV = F52W EPS / (TNX + Median ERP)

RAFV = $96.26 / (3.466% + 2.03%)

RAFV = 1751

And here's a chart that plots RAFV against the SPX since 9/11.

As you can see, the spread between the SPX and RAFV is now extremely wide -- not quite a wide as it was at the lows of '02, but not too far from it.

As you can also see, when RAFV has been above the SPX, it has tended to produce an uptrend on the SPX. And when RAFV has been at or below the SPX, it has tended to produce less positive price action on the SPX, or negative price action.

Does that mean that I think that the SPX will rally up to 1750? Probably not. Why? Because if stocks rally, bonds will probably sell off, which would raise bond yields and bring RAFV down toward Earth.

What this chart does say, however, is that, over the intermediate term, we are likely to see the stock market forming a fairly important low, and rallying to higher levels. Why? Because in the absence of galloping inflation there is no precedent for ERP remaining anywhere up close to the 4% area. And because RAFV is exerting a bullish pull on stocks.

And what will allow the stock market to rally? Most likely the deceleration of the rate of write-downs to mortgage-related securities. When the Financials are done purging their books, then buyers are likely to gain control of the stock market again.

I continue to suspect that, in the long run, there will be a lot of "writing up" of mortgage securities that are currently being written down. But it could still take some months before the writing down process is complete.

Translated concretely into a stock market forecast, I suspect we're working on an important market low. Whether we're still working on the "left" side of that low or whether we've turned the corner and are heading higher immediately...that I don't know. It will probably depend on whether the Financials miss, meet, or beat estimates for 1Q08. (Goldman reports on April 1, JP Morgan reports on April 16, and Merill on April 17, just to name a few.)

Best regards and good trading!